In our final Monday Market Insights piece of 2019, we asked, “How should people think about investing amid the realization that unpredictability is always a feature of financial markets?” In hindsight, we could not have posed a more relevant question. This year has been unpredictable in so many ways, and we doubt that a global pandemic causing the most abrupt economic slowdown in our lifetimes was a feature of many 2020 investment outlooks. But here we are again, faced with the challenge of investing in a world that feels as uncertain as ever.
Successful investing, in our view, always starts with having a plan, and we think constructing a proper plan is always built upon a high-conviction investment philosophy. Our highest-conviction belief is that successful investment outcomes are most often produced by finding an approach you can stick with, without making radical changes based on the prevailing market backdrop. We believe a diversified, purpose-built, asset allocation is foundational in this pursuit. We start by acknowledging that predicting market performance and asset class leadership is extremely difficult, and having thoughtful exposure to various asset classes is the most powerful way to avoid many of the behavioral traps that so often derail a solid strategy. We think these simple tenets allow for investment plans that are built for long-term survival.
We must acknowledge, however, that although seemingly simple, adhering to one’s investment plan in the depth of a market panic can be excruciatingly painful. This year, amid the fastest 30% market decline in history, we had numerous discussions with clients who wanted to make dramatic changes to their portfolios. This time always feels different…and scary. Although inaction during times of acute market stress can feel like apathy or worse yet incompetence, it is most often the proper prescription, and providing relevant perspective is likely our greatest client service.
For example, in early April the market still looked quite grim. However, pulling back one’s lens helped to ease the pain. At that time, a 70/30 stock/bond portfolio invested 10 years prior produced an average annual return of 8.2%. For context, if $1,000,000 was invested, it would have grown to nearly $2.2 million. That was down from a peak of $2.8 million in 2019, and anchoring to that all-time high (a form of recency bias) could cloud one’s perspective. Stocks had still averaged a 9.6% average annual return over the most recent decade, comparing quite favorably to history. Since adopting 500 stocks into the S&P 500 Index in 1957, the average annual return through 2019 was roughly 8.5%. So even after the big market drop, stocks had still performed better than average over the most recent 10-year period.
As we approach our client relationships with long-term planning and advice, this perspective is incredibly important. Even at the market lows, not much should have changed when thinking about retirement plans or the accumulated value in portfolios over the past decade.
Stocks have increased 42% since the S&P 500 bottomed on March 23. Did we predict this? Certainly not, but that is the key point. Predicting near-term market movements with any degree of precision is incredibly difficult, and an investment strategy predicated upon timing such movements is likely doomed to fail. Not only is “getting out” at the proper time challenging, but buying back in can be equally as hard, often resulting in leaving significant returns on the table. For most investors, failed market-timing can be lethal in terms of reaching long-term investment goals needed to drive a successful overall financial plan.
This most recent market crash and subsequent recovery highlight three of our foundational investment principles:
- Diversification and asset allocation protect us from our inability to predict the future.
- Patience: “It was never my thinking that made the big money for me. It was always my sitting.” Being patient is truly the key to long-term investment success. Since 1935, there are only two time periods where the rolling 10-year annualized return for stocks was negative. The first was during the Great Depression, and the second was during the Global Financial Crisis. The best investment strategies are the ones you can stick with over time.
- “Reversion to the mean is the iron rule of financial markets.” Especially when it comes to volatility and sentiment, extremes don’t last long. Periods of low volatility are always followed by periods of high volatility (and vice versa), while periods of pessimism are always followed by periods of optimism (and vice versa).
Early signs of an economic recovery are becoming clear, but given the depth of the initial contraction, we believe financial markets may already be pricing in a fair bit of the incremental improvement we are likely to see between now and year-end.
The nascent recovery is evident across a variety of economic measures and, to be sure, we are very encouraged to see the economy stabilizing. From manufacturing to housing, we believe the worst of the economic contraction may be behind us.
Sources: FactSet, Inc.; BMT
From a market perspective, that is particularly encouraging because stock prices reflect the anticipated future, not the past or present. The concern is that financial assets have recovered most of what was lost…the economy has not. It is possible that current stock prices are reflecting a reality that may take longer to materialize than many investors hope. If investors become disappointed by the speed of the recovery, stock prices may find it difficult to make meaningful progress from current levels. The chart below shows the extent of the current disconnect. Historically, stock prices have a high correlation with leading economic indicators like housing and consumer confidence. We have not seen this level of divergence between leading economic indicators and stock prices in a long time, if ever.
Source: Cornerstone Macro
The disconnect can also be seen between stock prices and corporate earnings. Here, we also see the early signs of a recovery, but the gap is still wide.
Sources: FactSet, Inc.; BMT
Over the last 20 years, the S&P 500 has had a 0.9 correlation with 12-month forward earnings expectations. Since the market bottomed on March 23, that correlation has been -0.9. Simply put, as the market continued to rise, earnings estimates continued to fall. We believe the historical relationship will reassert itself, and this can happen in one of three ways – the market can fall, earnings estimates can rapidly recover or some combination of the two. In any case, we should be clear on what equity markets need to continue to appreciate in the near term – significantly higher than average price-to-earnings multiples. For context, the S&P 500 is currently trading at 22x earnings expectations over the next 12-months. This represents the highest forward P/E multiple since the Tech Bubble, over 20 years ago.
For additional context, it usually takes years for earnings to return to their previous peak after an earnings contraction.
Source: Strategas Research Partners
Current forecasts estimate that 2021 S&P 500 EPS will be $162.19. This would be higher than the $161.53 earned per share in 2019. By historic standards this would be a lightning fast recovery. Although certainly possible, we think these expectations may be optimistic. Even if expectations for 2021 earnings hold through the end of this year, a 19 P/E multiple would still be required to maintain the current level on the S&P 500 of about 3,100. The average P/E multiple over the past 20 years is about 16. An above-average multiple is likely, in our view, given the tremendous amount of monetary stimulus being introduced; however, the risk/reward should at least be questioned when the critical element of the bull case is higher than normal valuations.
It is, therefore, easy to make the bear case for stocks. That said, investing in this environment is complex. On one hand, we believe the economy is in the early stages of healing, with the support of both monetary and fiscal policy makers. Over the next couple of years, things are likely to get better, not worse. On the other hand, we also think the healing will be quite slow, with numerous risks and potential pitfalls as we move through the rest of the year. Our positioning reflects this tug of war – within equities, we have a tilt toward cyclical oriented asset classes that should benefit from an economic recovery (and that are in many cases unusually cheap). However, to manage the heightened level of risk, we have recommended reducing overall equity exposure relative to one’s stated target. Should the gap between fundamentals and asset prices persist longer than investors currently anticipate, this will serve as a hedge against our other more cyclically oriented equity exposures.
Since 1928, the S&P 500 has predicted 87 percent of the U.S. presidential election winners and every presidential winner since 1984 using a simple formula. If the S&P 500 is positive in the three months ahead of the election, the incumbent party has won, and if stocks are lower, the opposition party has won.
Source: Strategas Research Partners
With former Vice President Joe Biden and President Trump largely off the campaign trail over the past couple of months due to the COVID-19 virus, the upcoming presidential election has arguably not been top-of-mind for investors. However, in our view, this will quickly change as we enter the back half of the year. The conventions for each party are slated for August, with the first of three presidential debates scheduled for late September.
Current polls, at least as of press time, have Biden leading Trump nationally and, more importantly, for the outcome of the election in each of the so-called swing states. Looking to Congress, the Democrats currently outnumber the Republicans by a sizable margin within the House of Representatives, and few believe the balance of power is likely to change after the election.
The story in the Senate is far different. Republicans currently hold a slim majority (53 seats) and have twelve seats deemed to be competitive in the upcoming election, vs. just four for the Democrats. Were Biden to win the election, the Democrats would need to add just three net seats to get to a 50-50 tally, which effectively gives them control, as the Vice President would break any ties. Current polling also shows that the Democrats will probably pick up enough seats to recapture the Senate, which would translate to full Democratic control.
The balance of power obviously matters a great deal, but arguably more so in today’s extremely polarized political environment. This has been clearly demonstrated in the signature legislation enacted by each party when they last held full control. For former President Obama, it is the Affordable Care Act that passed with zero support from Republicans. Similarly, for President Trump, it is the Tax Cuts and Jobs Act, that passed without a single Democratic vote.
History of Congressional Control
* Purple represents a tie
Recent history shows that “full control” generally tends to be fleeting, as it has occurred only six times over the last 40 years. As was the case the last two times each party had full control, were this to take place after November’s election, we think it is reasonable to assume that the Democrats would seize the opportunity to press forward with substantial legislation. From the standpoint of an investor, the more impactful items are likely to be on the tax and regulatory front. While a full discussion of the proposed changes is beyond the scope of this narrative, several of the more notable items are discussed below.
From the corporate perspective, Biden has gone on record to say that he wants to raise the corporate tax rate to 28%. The rate currently stands at 21% thanks to a cut enacted via the passage of President Trump’s tax reform package, so this would translate to a meaningful increase. While not knowing exactly how this would be implemented, by definition, it would lead to reduced after-tax earnings for U.S. companies as a whole. All other variables held constant, this would translate to some combination of either a higher effective P/E ratio for stocks, or lower stock prices, were valuation levels to remain constant. On a more granular level, small and mid-sized companies are likely to be more negatively impacted because they have historically had higher effective tax rates relative to large cap companies.
Includes a surcharge of 2.5% in 1970
Sources: Urban Institute, Brookings Institution, and BMT
On the regulatory front, energy companies would face a far more formidable operating environment, with Biden stating that he would move to “phase out fossil fuels.” Pharmaceutical companies would also face the likelihood of some type of price controls. Certain large cap tech companies may also fare poorly, as they don’t pay much in the form of taxes, and Democrats have indicated a desire to pursue these huge companies on antitrust grounds. Potential winners would be alternative energy, electric vehicles, and companies geared toward increased infrastructure spending.
Turning to personal income taxes, the tax increases being discussed would be aimed squarely at the highest income earners. The top rate for an individual, which was reduced to 37% by President Trump beginning in 2018, would move back to its previous level of 39.6%. The cap that exists on Social Security taxes (currently this 6.2% tax does not apply to earned income above $137,700) would be lifted, and the tax would then apply to all earnings. Deductions would also be capped for the top tax bracket. Further, long-term capital gains and qualified dividends, which currently receive preferential treatment, would be treated as ordinary income and taxed at much higher levels. For high income earners, the maximum tax on certain investment income (long-term capital gains and qualified dividends) would now be as high as 43.4%, up from the current level of 23.8%.
When President Trump’s tax legislation was passed in late 2017, opponents said it disproportionately benefited the wealthy. For the highest income earners, the proposed changes would not only undo certain elements of the Trump tax cuts, but substantially add to their tax burden in other areas.
Although it is hard to argue that higher corporate taxes wouldn’t pressure stock prices (at least initially), the impact of higher individual tax rates for the highest earners is far less clear. That said, significantly higher capital gains and dividend taxes would surely be a market headwind, in our view. At the very least, the election will soon become an important focus for investors, with stocks likely vacillating based on election headlines and polling throughout the fall.
The Juggernaut that is Large Cap Growth
U.S. Large Cap Growth stocks have been an impenetrable force for the last 15 years. The return spread between the Russell 1000 Growth Index (proxy for large cap growth) and other indices has continued to widen further during the past twelve months. Pinpointing specific reasons for large cap growth’s outperformance can be difficult, but we believe there may have been some structural factors at play.
Sources: FactSet, Inc.; BMT
When comparing growth and value, specific sectors and industries tend to fall into each group. For example, Value tends to emphasize higher dividend yielding companies (i.e., Utilities) as well as more cyclical segments of the market, such as Banks, Materials, and Energy. Growth, conversely, leans heavily toward Information Technology Software & Hardware as well as Consumer Discretionary.
Sources: FactSet, Inc.; BMT
It should be acknowledged that Amazon represents a significant portion of the Consumer Discretionary weight, but given the size of its Amazon Web Services (AWS) Cloud business, the company could conceivably be placed within Information Technology. The table below highlights the largest impacts to the relative cumulative returns between large cap value and growth over the past 10 years. The relative difference between these sectors and their roles in the global economy could help explain why Large Cap Growth has outperformed Value the last 15 years.
Sources: FactSet, Inc.; BMT
The Energy and Banking industries have suffered from structural changes that have arisen during the past 10 to 15 years. Energy stocks were surely impacted by the U.S. oil and gas renaissance that developed from hydraulic fracturing in Barnett Shale during 2005. As these new found energy resources began to grow in volume, their size reached a tipping point at the end of 2014 as U.S. oil production achieved levels equivalent with Russia and Saudi Arabia, suppressing the price of the commodity.
Similarly, Banks have also faced headwinds that include overcoming financial impairments from the 2008/2009 Financial Crisis, more stringent regulations and higher capital requirements. The latter two items have led to a more secure and stable industry, but also created a drag on earnings. The earnings drag is likely due to implementation costs as well as changes to their balance sheet composition, thus reducing risk and subsequent returns.
In contrast, the Information Technology sector has prospered for the past 15 years as semiconductor prices have continued to decline and advancement of wireless communication technologies introduced new possibilities. Measuring technologies’ impact on the economy can be challenging, but Oxford Economics and Huawei estimated in 2016 that the digital economy had grown 2.5x faster than global GDP over the past 15 years, and a $1 investment in digital technologies has led to an average $20 increase in GDP. This compares to a paltry $3 increase in GDP for $1 worth of non-technology investments over the last 30 years. Similarly, the U.S. Bureau of Economic Analysis (BEA) estimates that from 2006 to 2016, digital economic real value added grew at an average annual rate of 5.6%, compared to an average annual rate of 1.5% for the economy as a whole.
It seems clear that Growth- and Value-related industries have faced certain structural tailwinds or headwinds during the past 15 years. However, the important questions for investors are whether these trends will continue and what relative price investors should pay for stocks of each style. As part of our strategic asset allocation, we continue to believe a modest overweight to value can provide performance benefits over long periods of time. Relative valuations are not great at predicting short-term performance, but they are very useful in determining 10-year forward returns. The current relative valuation extreme between growth and value gives us confidence in our positioning. We continue to believe a tilt towards value remains in our clients’ best long-term interest as the current relative valuations being paid for growth stocks are well beyond historical levels.
Sources: FactSet, Inc.; BMT
Investing in REITs – A Dangerous Time?
Following the recent introduction of our BMT Custom Equity Portfolios and new Strategic Asset Allocation, we have received several inquiries about our direct allocation to Real Estate Investment Trusts (“REITs”). Client questions have mostly focused on the “Why Now?”, along with concerns of REIT exposure to brick-and-mortar retail.
What is a REIT?
A real estate investment trust, or REIT, is a company that owns or finances income-producing real estate across a range of different property types. REITs generate revenue mostly from leasing space and colleting rent on its properties and they must meet certain criteria to be designated as such. The primary benefit of a REIT is that dividends do not fall victim to double-taxation like other companies. If a REIT meets all necessary requirements, it is not taxed at the corporate level, and can more efficiently distribute earnings to shareholders with no drag from corporate taxes. One of the requirements stipulates that a REIT must distribute at least 90% of its taxable income to shareholders as dividends, so REITs tend to have relatively high dividend yields.
Why REITs and Why Now?
Our BMT Strategic Asset Allocation and BMT Custom Equity Portfolios incorporate direct exposure to REITs as we expect the asset class to provide long-term benefits to investors. As part of our asset allocation process, we determine our capital market assumptions, or our expectations for the future returns, risk, and correlation among different assets. Our projections are that over the next decade, REITs should provide better average annual returns with less risk (standard deviation) then a large cap equity portfolio. In addition, REITs should provide a diversification benefit to an investor’s overall portfolio due to the asset class’s lower historical correlation to the equity market. Over the past ten years (as of 5/31/2020) the FTSE Nareit All REITs Index has had a 0.70 correlation to the S&P 500 and a 0.68 correlation to the Russell 2000. For diversification benefits this compares favorably to the 0.91 correlation between the S&P 500 and Russell 2000 indexes.
Investing in REITs – A Dangerous Time?
Investor concerns about REITs have come back into the spotlight as a result of COVID-19. This is due to the possible future implications on how the world will work and shop in the years post-COVID. Frequently, REITs are assumed to consist largely of Retail and Office properties. While these are areas that often come to mind, it is not necessarily how REIT funds are composed.
Below, BMT’s REIT exposure been categorized by Sub-Industry using S&P GICS classifications. As the table displays, the exposure to Office and Retail REITs is quite modest, constituting a combined 16% of the fund we use. When considering BMT’s strategic asset allocation to REITs is 4%, the overall portfolio exposure to the Office and Retail REIT sub class is 0.6%.
Sources: FactSet, Inc.; BMT
Within the Office and Retail sub-industries, the individual exposures to each holding are also small, with the average weight of an Office REIT being 0.39% and an average Retail holding of 0.25%. The largest exposure in our REIT allocation is in a category called “Specialized REITs.” These are typically REITs that do not fit nicely into one of the other categories and may own unique assets. The Specialized REIT category is made up of companies that hold a range of assets from communication towers and data centers to self-storage facilities — not the first types of companies that most investors envision when they think of REITs. To be fair, the REIT space has made quite a transition during the past decade. The table below displays how drastically the composition of REIT property sectors has changed.
Sources: FactSet, Inc.; BMT
The largest individual constituents in our exposure are concentrated in the Specialized category and one large position in an Industrial REIT, Prologis, Inc. The largest concentrations are in three communication tower stocks, (American Tower, Crown Castle International, SBA Communications), two data center REITs (Equinix and Digital Realty Trust), and the previously mentioned Industrial REIT (Prologis).
Sources: FactSet, Inc.; BMT
Since ~35% of our REIT fund is invested across three specific end-markets, we felt it would be helpful to explain how these companies generate revenue and what their future may look like.
The communication tower or “Tower” REITs (American Tower, Crown Castle, and SBA Communications) have similar business models. At a high level, these companies have acquired and constructed the large metal towers used for positioning antennas for wireless carriers and other communication companies. This industry has a resilient business model and their main customers are the three national wireless carriers; Verizon, AT&T and T-Mobile. The tower companies have benefited from a trend towards co-location, a theme that led to the carriers divesting many of their towers. Communication towers require a large amount of upfront investment to build with minimal costs for upkeep. A single tower can accommodate multiple carriers or “tenants”. When different telecom providers are positioned on the same tower, it is called co-locating and has significant efficiency benefits. The Tower REITs act as a neutral third-party to the wireless carriers, allowing for the co-location of multiple carriers on a single tower. This allows wireless providers to meet the communication demands of a specific geography with the least amount of investment. This model is beneficial for all parties, consumers, wireless carriers and tower REITs. Consumers benefit from faster data and fewer unsightly towers, carriers benefit from the shared investment cost and maintenance, and tower REITs benefit from the high incremental margins of adding additional tenants to a fixed cost asset. In the coming years, tower REITs are anticipated to benefit from rising mobile data consumption, network densification, 5G maturation and the prospects of edge computing.
The data center REITs, Equinix and Digital Realty Trust, benefit from similar attributes as towers, such as colocation. Data center REITs are typically vendor-neutral locations that supply the required infrastructure to support and rent out space where multiple tenants can install their own IT servers for various use cases. Similarly, to towers, these data center providers offer a way to reduce a tenant’s upfront capital investment and increase the overall utilization of technology infrastructure. In addition, the data center REITs are frequently interconnected or located near tenants’ suppliers, increasing the performance potential of networks and delivery speed to end users. Data center REITs are expected to benefit from future growth of data consumption, the need to reduce latency, and the continued transition to public and private cloud environments.
Prologis is the third largest holding in the fund we use and represents a significant percentage of the Industrial REIT space. Prologis is a provider of logistics-related real estate and is best described as an owner and renter of space used for supply chain distribution centers. These distribution centers are utilized for delivery to a retail store or as a final touch point for delivery to the end consumer. The rising share of e-commerce retail has benefited Prologis in several ways. Prologis customers can benefit from the sharing or co-locating of inventory in leased space and Prologis’s significant size provides pricing power for supplies such as light bulbs. These savings can be significant when viewed on a large scale. Prologis also has pricing power with its tenants as a result of its strategic property locations. Prologis benefits from a shrinking available land footprint surrounding urban areas where proximity to the end consumer is crucial. Proximity has grown even more important as online retailers look to reduce delivery times and expenses. Prologis has buildings spread across four different categories; Multi-market distribution, Gateway Distribution, City Distribution, and Last Touch. Each of these categories has its own use case, but act as important nodes on a product’s journey to the end customer. The City Distribution and Last Touch locations command the highest rent per square foot and represent about 53% of Prologis’s locations. The company’s well positioned distribution centers should allow for annual rent increases and high facility utilization rates. Prologis and peers should benefit from the increasing penetration of e-commerce and need to reduce delivery times and costs.
Clearly, there have been significant changes in the REIT space, ones that we believe will benefit from secular growth in technology and e-commerce. Couple these business tailwinds with the benefits of above market dividend yields and diversification and we believe a properly sized allocation to REITs makes sense for the long-term.
Federal Reserve Chairman Jerome Powell has reiterated numerous times via various speeches, press conferences, and interviews that the Federal Reserve (Fed) stands ready to do whatever is necessary to support the U.S. economic recovery in the aftermath of the worst economic contraction since the Great Depression. Given the Fed’s Summary of Economic Projections, it is highly likely that monetary policy will remain very accommodative for years to come as the Fed utilizes its traditional and non-traditional policy tools to increase inflation towards 2.00% and bring the labor market back to full employment.
Thus far, the Fed has lowered the federal funds target range between 0% and .25% and projects this range will remain unchanged through 2022. The nearly unanimous forecast shared by 15 of the 17 participants of the Federal Open Market Committee (FOMC) reflects very little dissention among committee members, underscoring the likelihood that low borrowing costs will be appropriate for many years to come.
This form of forward guidance from the Fed is extremely valuable to market participants as it sets interest rate expectations for short-term borrowing costs. When combining today’s low interest rates with a projected timetable it decreases interest rate volatility within the short part of the yield curve, which is most sensitive to Fed policy. The Fed’s forward guidance will most likely keep short-term interest rates well anchored near 0.0% so long as their communication remains consistent with their policy objectives.
Interestingly, if low, short term rates have their desired effect, economic growth and higher levels of inflation should naturally increase over time as business and consumer spending gradually improve. In this instance, longer term interest rates may increase coinciding with an improving economy and rising inflation.
For example, on June 5, when labor market data for the month of May was reported better than expected, the 10-year U.S. Treasury yield increased to 90 basis points (0.90%) compared to 65 basis points (0.65%) from just a week earlier. Although the economic data was welcomed news, on June 10 during the post FOMC meeting press conference, Chairman Powell downplayed its significance noting that the high unemployment rate will take time to fully recover and that continued low interest rates are certainly appropriate. His remarks contributed to the 10-year maturity ending the day at 73 basis points (0.73%) as investors reassessed their interest rate expectations.
When the Fed speaks the market listens. This is a good example how effective and powerful forward guidance and Fed communication can be when interest rates stray too far away from the Fed’s comfort levels. A steeper yield curve that resulted from investor economic optimism was mostly reversed in anticipation of dovish Fed comments that subsequently followed.
US Yield Curve – Spread Between 10 year and 2-year maturity
(May 29, 2020 – June 12, 2020)
Source: Bloomberg, Inc.
Another widely used and effective tool by the Fed has been quantitative easing or simply stated, Fed bond purchases. The Fed has been expanding its balance sheet purchasing U.S. Treasury and agency mortgage backed security across the yield curve. The benefit of quantitative easing is that the Fed can better influence longer-term yields by focusing on bond purchases of a longer maturity. When buying bonds, the Fed is adding an extra source of bond demand that puts downward pressure on yields.
The Fed has recently announced that it will be purchasing at least $80 billion in U.S. Treasuries and $40 billion in mortgage securities spread out across the yield curve each month. Since mid-March, the Fed’s balance sheet has ballooned to over $7 trillion as the Fed not only aims to increase market liquidity, but also reinforce lower long-term bond yields.
Federal Reserve Balance Sheet
(December 31, 2019 – June 17, 2020)
Source: Bloomberg, Inc.
Collectively, forward guidance and quantitative easing have been very effective in keeping interest rates low. It’s clear the Fed remains committed to doing all it can to support economic growth by maintaining policies aimed at keeping borrowing costs accommodative for consumers and businesses.
It’s also obvious that the Fed stands ready to do more either via existing, or new, policies to further promote economic stability.
Yield curve control (YCC) is another policy that hasn’t been used in the U.S. since the 1940’s, but has currently received much attention by FOMC participants. YCC involves the Fed targeting yields of specific maturities on the yield curve. Similar to quantitative easing, YCC involves buying bonds, but focusing on specific maturities in which yields are trading above a certain threshold. For comparison, Japan has been targeting a 10-year government bond yield near 0.0% and has managed to keep the yield from increasing too much above this threshold since mid-2016 when the policy was first announced.
We believe yields will remain low, in line with accommodative monetary policy from the Fed for as long as it takes to get the labor market back to near full employment and annual inflation approaching 2.0%. We expect the Fed will utilize all tools as appropriate to ensure borrowing costs remain accommodative and conducive to economic growth. In our view, this mean the likelihood of a significantly steeper yield curve is somewhat diminished, even if economic growth and inflation begin to rise.
The U.S. corporate bond market was under tremendous pressure beginning in early March. Fears of the coronavirus pandemic spread quickly through the financial markets leading to increased investor risk aversion and market dysfunction. An abnormal amount of bond selling was met with very little investor demand, contributing to very illiquid lending markets and a spike in corporate borrowing costs. Companies that normally use the capital markets for funding firm projects, rolling over existing debt, managing working capital, etc., were forced to look elsewhere to boost liquidity.
A well-functioning financial system is a necessity for a healthy economy. One can’t exist without the other. Resolving the lack of liquidity and dislocations within the lending market became top priority of the Federal Reserve (Fed) and they took important steps to bringing stability back to the financial system.
On March 23, the Fed unveiled several programs, facilities, and initiatives to increase market liquidity and ease the flow of credit to those in need – individuals and businesses. Although the Fed’s announcement included a number of actions, the two most notable for the corporate bond market included the Primary Market Corporate Credit Facility (PMCCF) and the Secondary Market Corporate Credit Facility (SMCCF).
As the names imply, the PMCCF focuses on bond purchases in the primary market providing new funding directly and immediately to eligible companies whereas the SMCCF focuses on already issued corporate debt that is currently trading within the bond market. Combined, the programs created a substantial amount of buying power for the Fed to the tune of up to $750 billion. For comparison, roughly $1.4 trillion of U.S. corporate bonds were issued in 2019.
Interestingly, on March 23, the day the Fed programs were announced, credit spreads had reached 373 basis points, its highest level since the financial crisis and the peak level so far this year. Credit spreads have since moved substantially lower closing at 150 basis points on June 30, 2020, only 9 basis points above their 10-year average of 141 basis points. A remarkable and much needed turnaround within the lending markets.
Bloomberg Barclays US Agg Corporate Average OAS
(December 31, 2019 – June 30, 2020)
Source: Bloomberg, Inc.
Liquidity vastly improved and corporations stampeded back into the market. In fact, investment grade corporate issuers have issued over $1 trillion of corporate debt YTD through May 31, 2020, the shortest period needed to cross the $1 trillion threshold. Both buyers and sellers reentered the lending markets as corporations were anxiously awaiting to borrow.
The Fed was undoubtedly successful in bringing stability back to the lending markets, the primary focus of Fed programs and initiatives. However, the U.S. economy is currently in recession while corporations are warning investors of sharp revenue declines triggered by stay-at-home orders and lock downs that have only recently been lifted. Whether or not a second wave of the virus reappears, or a therapy/vaccine becomes available soon, both remain important uncertainties weighing on the markets.
Although these uncertainties exist, investor’s appetite for corporate bonds remain healthy. Since the Fed intervened back on March 23, credit spreads have continued to trend lower leading to lower corporate borrowing costs. Based on the Bloomberg Barclays U.S. Aggregate Corporate Bond Index, the yield to worst was at a record low of 2.15% as of June 20, 2020, when looking at the past 30 years.
Bloomberg Barclays US Agg Corporate Yield to Worst
(June 30, 1990 – June 30, 2020)
Source: Bloomberg, Inc.
Corporate issuance has also been a positive for those companies who have been able to strengthen their balance sheets and overall liquidity. It’s worth noting that the jump in corporate issuance thus far has easily been absorbed by market participants with little upward pressure on credit spreads and with very little bond demand from the Fed.
Interestingly, the Fed has barely scratched the surface with their Exchange Traded Funds (ETFs) and bond purchases and is well below the $750 billion purchasing limit. As of the end of the second quarter, they have purchased roughly $10 billion of eligible securities.
We continue to believe corporate issuance will be well received by investors although the market will most likely be exposed to bumps along the way, some potentially larger than normal. In these instances, the Fed has ample ability to provide liquidity, therefore greatly reducing the chance of a persistent spike in credit spreads. Criticism of whether the Fed should be doing what they are doing aside, we must play the hand we are being dealt. As such, we believe credit spreads should be well anchored from retesting prior highs given the Fed’s expressed commitment to do more if economic conditions materially worsen.
When economies around the U.S. were locked down starting in March, it forced many businesses to quickly adopt a model where most of their employees were working from home. It was a lesson in forced feasibility brought on by COVID-19. In general, the findings from this multi-month “experiment” were very encouraging, prompting employers to consider permanently shifting at least some of their operations to this type of an operating model.
Comments supporting the likely move in this direction abound, with the CEO of Facebook, Mark Zuckerberg, saying that 50% of his employees could be working from home in 5-10 years. Twitter told their employees in May that they could work from home indefinitely. The advent of Zoom, Microsoft Teams, Slack, along with other technologies, have made it possible for corporate America to contemplate this move.
At a minimum, it would appear likely that the need for many businesses to have all, or most, of their employees working in an office will not be the base case going forward. While much remains unknown as to how widely this model is adopted, we think a significant number of organizations will move in this direction. This will clearly benefit certain industries, but in most instances these industries were already experiencing strong underlying growth trends. Sadly, many of the companies and industries that have already been hard hit by the pandemic, are likely to face ongoing headwinds from the move to conduct business (including client interaction, prospecting, etc.) remotely.
At the top of list of companies benefitting from this trend will be technology companies that enable work from home, and the secure storage and transmission of company data. Networking, cloud based, and information security stand to be prime beneficiaries. Software that allows employers to track employee productivity should also benefit. With employees no longer required to be located near the office, we also envision a degree of migration by those employees away from high cost of living cities. This would benefit lesser populated areas of the country at the expense of densely populated metro areas.
Not surprisingly, Wall Street has at least one work from home related Exchange Traded Fund (ETF) in the registration process, and another firm has launched a Remote Work Index to track the performance of these stocks. That Index, constructed by Solactive, is comprised of forty companies which reside almost exclusively within the Tech and Communications Services sectors, two areas which have performed well of late. Still, as the chart below displays, the outperformance of these issues (relative to the S&P 500) since the remote from work model was made necessary, has been noteworthy.
Sources: Bloomberg, Inc.; and BMT
Looking more specifically at the top five performing constituents within this new Index, they have advanced an average of 118% in 2020 vs. a decline of 4.5% for the S&P 500. While those returns are impressive, relative valuations for these holdings are immense, selling for an average 41.4x trailing twelve-month revenues (S&P is 2.2x) and 392x estimated operating cash flow (S&P 500 is 12.2x). While we acknowledge the likelihood of a shift in habits which should benefit these holdings, the premiums accorded to the group arguably leave very little room for any type of disappointment.
Companies and industries likely to come up on the short end of this trend are more expansive. The move away from metro areas (where most jobs are currently located) would certainly impact apartment REITs oriented towards these markets. On a similar note, office REITs are likely to suffer, not immediately due to the multi-year terms of most leases, but over the longer-term as companies reassess their needs for physical space. On these two real estate related points, investors are already acknowledging the likelihood of these headwinds, with many large city office and apartment REITs underperforming the broader REIT category.
The travel industry, already suffering mightily, also stands to lose in a world more oriented toward remote work. The effectiveness to interconnect over the computer will have companies reassessing travel budgets on a longer-term basis. For airlines, this is particularly bad news, as business travelers are their most profitable customers. This obviously has longer term ramifications for others along the travel chain, including hotels, convention centers, and to a lesser degree, restaurants.
As noted above, how widely the work-from-home model is adopted remains to be seen. We certainly acknowledge the benefits of face-to-face interactions, and know many will return to their offices and prior business travel regimen. Still, driven by cost savings and an added benefit to employees, a shift towards working from home seems likely, at least at the margin. For certain companies that stand to benefit from this trend, given recent moves in their share prices, expectations appear lofty.
Recently, it has become clear that rising tensions between the United States and China were not cured with the signing of the 2019 trade deal. The trade dispute between both nations, which began in March 2018, escalated for nearly a two-year period before a tenuous deal was eventually reached in January of 2020. At the beginning of this year, it seemed that geopolitical dissension was beginning to subside and that relations between both hegemons were starting to marginally improve.
Budding diplomacy related trade/economic matters has now taken a back seat to culpability pertaining to the COVID-19 pandemic. The outbreak of COVID-19 in late January/early February originated in Wuhan China. Many U.S. leaders have claimed that China did not reveal the severity of the problem and was not forthcoming with information and policies that could have curtailed its spread. Chinese officials have dismissed such claims and have cited that the United States failed to adopt measures to mitigate the negative economic and health effects caused by the virus. Irrespective of one’s view in terms of which nation bears greater responsibility, tensions have clearly escalated.
While the underlying source of contention between the United States and China has varied since the People’s Republic of China was founded by Mao Zedong in 1949, the effect on financial markets over the last several decades has largely been inconsequential, other than at times, prompting transitory fluctuations in asset prices.
The last two superpowers that clashed (figuratively speaking) over roughly a 40-year period (1950-1990) were the United States and the Soviet Union. Investment returns fluctuated considerably over various rolling 12-month windows, but as you can see in the chart below, performance for equity and fixed income asset classes was quite favorable for U.S. markets over this period.
|Return||Standard Deviation||Min*||Max Gain*|
|IA SBBI US 30 Day TBill TR USD||5.20||0.90||14.71||0.86|
|IA SBBI US IT Govt TR USD||5.85||5.20||29.10||-4.61|
|IA SBBI US Large Stock TR USD Ext||12.49||14.29||61.18||-26.47|
|IA SBBI US LT Govt TR USD||4.76||9.10||40.71||-12.26|
|IA SBBI US Small Stock TR USD||14.92||19.72||97.65||-44.45|
*Min and Max Gain are calculated based on rolling 12-month returns with a 6-month lag in-between each period.
Source: Morningstar, Inc.
A case could be made that over the very long-run (20 or more years), the ebb and flow of adverse geopolitical events (military confrontations, terrorist threats, trade disputes, etc.) does not have a significant influence on investment outcomes. However, we believe that a contentious relationship between the world’s two largest economies could be quite disruptive over the near-term and materially affect market volatility and the relative performance of asset classes. As result, we believe it’s worth assessing potential investment implications, or how to position equity portfolios, if relations between the U.S. and China improve, remain the same, or deteriorate further.
We elected to examine this question using two different approaches. The first method was to look at how rising and falling tensions between countries have historically impacted investment results across geographic regions. We analyzed the Geopolitical Risk Index (“GPR”) – an algorithm created by Federal Reserve economists Dario Caldara and Matteo Iacoviello, which tracks key word/phrases of the electronic archives of 11 national and international newspapers. This data is used to compile a numerical value that measures geopolitical risk, which is further delineated by “Acts” and “Threats.”.  The data starts in 1985 and is tabulated on a monthly basis. A higher number is indicative of heightened levels of geopolitical risk. The following chart denotes specific incidents that have resulted in spikes in the GPR Index. It also shows the average levels of different time periods over the last 30+ years. The chart below does not include more recent events, including the COVID-19 virus pandemic.
Geopolitical Risk Index
Source: “Measuring Geopolitical Risk” by Dario Caldara and Matteo Iacoviello at https://www2.bc.edu/matteo-iacoviello/gpr.htm. Schroders Investment Management calculations and annotations, 11 April 2019
We analyzed how U.S. equity markets (S&P 500 Index) fared in relation to international developed stocks (MSCI EAFE Index), emerging markets (MSCI EM Index), and Chinese equities (MSCI China Index) when the GPR Index was at different levels. We grouped the monthly GPR Index levels by decile (1-lowest risk, 10-highest risk) and then calculated the average monthly return difference between U.S. and international equities over each measurement period. When examining the data beginning in January of 1986 (see chart below), U.S. markets have fared better during extreme outlier scenarios, meaning when geopolitical risk was at its highest or lowest levels. Other than the outlier periods, there does not appear to be any pattern in the data. Since Donald Trump was elected President in November of 2016, the average GPR Index level has been quite high, ranking in the 86th percentile, relative to historical averages. Over this period, the S&P 500 Index monthly returns, on average, exceeded those generated by the MSCI EAFE, MSCI EM, and MSCI China indices, by 71,70, and 18 basis points, respectively.
While there are many factors that can influence the relative returns across geographic regions, a case could be made that the material underperformance of international stocks can at least be partially attributed to the heightened levels of political unrest. In our opinion, further escalation would likely pose a headwind for international stocks. Although the Trump Administration is clearly displeased with China’s response to the pandemic, we don’t think the imposition of policies that could further disrupt the economy or financial markets during an election year are likely. Also, relative valuations are more attractive for international equities, and those indices have more cyclical sector exposure, which should bode well during a post COVID-19 recovery. Therefore, we think meaningful exposure (about 30% of an equity portfolio) to international stocks is still justified even if geopolitical unrest remains elevated.
|GPR Index Levels & Relative Returns Between U.S. & International Stocks (1/1986-5/2020)|
|GPR Decile Rank (1-least tension, 10-highest tension)||S&P 500 vs MSCI EAFE: Avg. Monthly Return Diff. (%)||S&P 500 vs MSCI EM: Avg. Monthly Return Diff. (%)||S&P 500 vs MSCI China: Avg. Monthly Return Dif. (%)|
|*Denotes the most recent GRP Index Level (May 2020)|
Source: Morningstar, Inc., https://www.matteoiacoviello.com/gpr.htm#data
Second, we decided to look at geographic revenues across sectors of the S&P 500 Index to see which areas have the most direct revenue exposure to China, which could be problematic if tensions rise. We also looked at operating margins, valuations, and profitability measures (ROE). This data is illustrated below.
|Geographic Revenue, Profitability, and Valuation for GICS Sector Based ETFs: June 2020 Data|
|Ticker||US Revenue||Mainland China Revenue||Total EM Revenue (%)||Operating Margin||P/E||ROE|
Source: FactSet, Inc.
Technology stocks have clearly been a positive performance outlier during recent periods of market stress: the trade standoff between the U.S. and China, the COVID-19 virus induced market panic, as well as the subsequent rally. This may come as a surprise given the percentage of revenue tech stocks derive from overseas operations. We do think that this sector could be adversely affected if tensions between the U.S. and China remain elevated or continue to escalate further, especially if global trade as a percentage of GPD starts to decline. More than half of all tech stock revenues are generated from overseas operations. Also, tech stocks, on average, have the highest profit margins and valuations, which could make them vulnerable if input costs rise given supply chain disruptions and revenue generated from China operations falter. Therefore, we are comfortable being underweight Technology stocks at this juncture.
An “Unconstrained” equity category was incorporated into BMT’s newly introduced Custom Equity Portfolios. This segment of the portfolio, which we expect will average roughly 10% of total equity assets over time, was designed to utilize unique investment products that do not neatly fit into a conventional asset allocation style box (i.e., large value, small growth, etc.). The purpose of this sleeve is to improve risk-adjusted returns over the long-run.
At this time, there are two volatility-based investment strategies held within the Unconstrained category – one long volatility, and one short volatility strategy. They collectively total a 6% weight in all BMT Custom Equity Portfolios. The addition of volatility-based strategies may raise a few questions, some of which are addressed below.
How does one invest in volatility?
We define volatility as the standard deviation (measure of dispersion of dataset relative to its mean) of returns generated by an investment. Realized volatility is the historical standard deviation of asset prices measured over a specified time period. The CBOE Volatility Index, or VIX, is a real-time market index representing the market’s expectations for volatility over the coming 30 days. Investors will often use the VIX to measure the level of risk, fear, or stress in the market. The VIX tends to rise when equity markets fall, as the VIX derives its value from the pricing of put and call options. Simply stated, as equity markets become stressed, put options become increasingly expensive as more investors want to protect their equity holdings. This translates into a higher VIX index level. Investors can get exposure directly to the VIX index using a variety of options, futures, and exchange-traded products.
Why can this exposure be useful when constructing a diversified portfolio?
When managing portfolios, we are attempting to obtain the highest return for a given level of risk. We believe that if done properly, an effective volatility-based strategy can generate returns over time that are comparable to global equities, while also having a low or potentially even negative correlation in times of material market stress. We think that these attributes provide an added level of diversification that is very hard to find from other asset classes, including bonds.
Correlation amongst asset classes tends to rise during material market declines, which is unfortunately the time when diversification within a portfolio is most needed. As you can see from the table below, the VIX is the only index that did not experience a rise in correlation relative to the S&P 500 Index during the worst 6-month stretch of the 08/09 Financial Crisis. Even the Bloomberg Barclays Aggregate Bond Index saw a significant increase in correlation to stocks. By design, and given the drivers of its price, the VIX moves in the opposite direction of stocks.
|Asset Class Correlation and Risk (Equity Beta) Data|
|20-Years Ending 6/30/20||6-Months Ending 3/31/09|
|S&P 500 TR USD||1.00||1.00||1.00||1.00|
|Russell 2000 TR USD||0.89||1.18||0.97||1.25|
|MSCI ACWI Ex USA GR USD||0.87||1.00||0.97||1.17|
|BBgBarc US Agg Bond TR USD||-0.08||-0.02||0.64||0.17|
|Bloomberg Commodity TR USD||0.40||0.42||0.84||0.76|
|CBOE Market Volatility (VIX)||-0.69||-3.70||-0.72||-2.13|
Source: Morningstar, Inc.
What are some differentiating features of the way BMT chooses to approach this asset class?
We first must highlight the challenges of investing in volatility. Thus far, we’ve made it sound too easy. When looking for long volatility exposure in a portfolio there is one critical concern. Because volatility (represented by the VIX), generally moves in the opposite direction of stocks, and stocks generally rise over time, long VIX exposure has a negative expected return – in other words, you will slowly bleed returns over time. A static, or constant, long-volatility exposure requires a constant rolling (new premium payments) of futures contracts, which is what leads to the return drag. Investors will also often short volatility, which can pay off handsomely in a bull market as the VIX stays low. For example, SVXY (a short volatility ETF), was up almost 750% from February 2016 through January 2018, as the VIX remained exceptionally low. The catch – and there is always a catch with returns that good – is that when the VIX spiked in early 2018 during a swift S&P 500 sell-off, SVXY dropped 92%, shorting volatility can be a dangerous game.
The path we have chosen is different. Our exposure utilizes a dynamic approach by increasing/decreasing exposure to VIX linked investments based on trends in volatility. In other words, you are never statically long volatility (bleeding returns over time) or statically short volatility (exposed to massive reversals and subsequent loss). The strategy we use is 100% algorithmic, with no human judgment involved. The approach is based on a simple yet critical idea – human behavior is one of the most powerful forces in financial markets, and because of that, volatility reliably trends. When the VIX starts to quickly move higher, it usually continues to do so (people panic), and when the VIX is low, it tends to stay low (people get greedy).
Therefore, our volatility exposure adapts to changing market conditions, which we think will negate the shortcomings (roll factor, volatility spikes) associated with most volatility-based investing strategies. Specifically, the manager we use attempts to detect patterns that consider the autocorrelation of volatility when rotating in and out of volatility exposure. When the VIX is low, their long volatility strategy rotates into mostly S&P 500 exposure, negating the typical performance drag and allowing investors that participate in a bull market. As volatility starts to rise, the strategy begins to rotate into long-VIX exposure. The short vol strategy will adjust the allocation to cash, Treasuries, and short VIX futures depending on volatility levels and directional shifts.
By adding a 75/25 (long vol/short vol) blend, we believe we are accomplishing one key goal – introducing a product that can produce equity-like returns over the long-term, with a negative correlation to equities during a market crisis.
 Edwin Lefevre. “Reminiscences of a Stock Operator”. 1923
 Bogle, Jack. Founder of Vanguard.
 The REITs described herein are for illustrative purposes, only. Would only be part of a diversified portfolio at BMT. Are not representative of the investment performance of a diversified portfolio. May go down in value. Past performance is no guarantee of future results.
 BMT Wealth Management 2020 Capital Market Assumptions
 Table shows the largest sub-industry groupings
 For more detail see “Measuring Geopolitical Risk” 9 November 2017 by Daniel Caldera and Matteo Iacoviello.
 Autocorrelation just means something is correlated to itself – if the last price move was higher, the next price move tends to be higher. If the last price move was lower, the next price move tends to be lower. Volatility is the only asset class that exhibits this characteristic reliably, and as explained above, the explanation is simply human behavior.